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348 Incredible Companies

Small really is better.

The 10 best-performing stocks of the past decade were obscure, ignored, and small. But what about the top 25? The top 50? The top 100?

It turns out that most of the stock market's greatest performers of the past 10 years were also obscure, ignored, and small.

Small stocks for big returnsFrom January 1997 through December 2006, 348 stocks could have earned you greater-than-20% annualized returns over the past 10 years -- turning a $10,000 initial investment into more than $60,000. Of those 348 stocks, 325 of them were small caps 10 years ago. That's more than 93%. While the companies run the gamut from fashionable clothier Urban Outfitters(NASDAQ:URBN) to humble oven maker Middleby(NASDAQ:MIDD), the common thread is size.

Ten years ago, Urban was a tiny $230 million company. Today, it's worth more than $4.1 billion. Middleby grew from its $53 million valuation to $900 million, rewarding shareholders along the way.

And Middleby, for one, is still growing. The company dominates its niche and has almost every trait investors should look for in a small cap: superior leadership, clear competitive advantages, and impressive and improving returns on equity and assets. Since we recommended it in our Motley Fool Hidden Gems small-cap investing service, it has also returned more than 500% for our members -- but we're confident it will keep on performing over the long term.

Big stocks for smaller returnsOnly 23 mid- or large-cap companies would have given you the same growth, and they're the cream of the crop: UnitedHealth(NYSE:UNH) and Valero Energy(NYSE:VLO), to name two. And while the returns have been incredible from these firms -- both of which demonstrated some key traits of great small caps, including strong financials, strong competitive position, and strong leadership (the McGuire options fiasco notwithstanding) -- they're just not as prevalent as the small guys.

That's because it's difficult for larger companies to generate the same kind of growth as small caps. While Middleby grew from $53 million to $900 million, United Health grew from an $8 billion valuation to nearly $75 billion. While UnitedHealth added substantially more value in absolute terms, the story changes when it comes to stock prices and percentages. Middleby stock returned more than 1,500%; UnitedHealth returned 855%. Now compare that with a much larger company, such as General Electric(NYSE:GE). The conglomerate added $220 billion to its market cap during the same 10-year span, yet its investors gained only 126%. That's a consequence of the Law of Diminishing Returns, and it's a simple and crucial point in investing.

The Foolish conclusionSmall caps are one area of the market where individual investors have the opportunity to earn phenomenal returns -- but there are also pitfalls. For every one of the 348 small caps that could have earned you greater-than-20% annualized returns over the past 10 years, quite a few more didn't make it. Small-cap stocks tend to carry considerably more risk than large caps, so investors must consider their investments very carefully.

That's why we advocate a diversified portfolio of select small caps for Hidden Gems subscribers. By focusing on factors like superior management and a strong balance sheet and enjoying the benefits of diversification, our small-cap recommendations have outperformed the market by nearly 30 percentage points since we started.

Every investor should have at least some smart exposure to small caps, because the historical profits are just too good to pass up. If you'd like some help getting started in this incredible area of the market, click here to join our community free for 30 days.

This article was originally published on Feb. 6, 2006, as "325 Incredible Returns." It has been updated.

Tim Hanson does not own shares of any company mentioned. UnitedHealth is an Inside Value and Stock Advisor recommendation. No Fool is too cool for disclosure.